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In the President’s speech to Congress on Thursday, Sep 8, he referenced a new program that he would initiate to assist homeowners with their housing woes. Details of the proposal have not been released, but it is known that a draft of a proposal has been circulating in Washington. (The draft is by Alan Boyce, Glen Hubbard and Chris Mayer. Boyce is CEO of the Absalon Project; Hubbard is Dean and Russell Carson Professor of Finance and Economics at Columbia Business School; Mayer is Paul Milstein Professor of Real Estate, Finance and Economics at Columbia Business School and Visiting Scholar at the Federal Reserve Bank of New York.)

Overview from Report

• 75% of all GSE loans have an interest rate of 5% or greater. Current rates are in the low 4’s. The plan is to refinance these loans to lower rates, reducing monthly payments, and providing the homeowner additional cash to spend in the economy.
• Homeowners are unable to refinance due to “Falling Home Values”, Low Appraisals, and Financing Costs. With this program, a homeowner can refinance underwater homes to any loan to value, provide no income documentation, and a complete disregard for credit scores, provided that the borrower is up to date on the mortgage and has been so for three months.
• Only First Mortgage debt eligible. Second Mortgages cannot be refinanced into the new mortgage. Any second mortgage must be re-subordinated as a second mortgage.
• New MBS would be issued for the refinances. They would trade between 3.2 and 3.4% yields.
• New guarantee fee of 40 basis points to compensate the GSEs for their costs of implementing this plan, for any possible revenue lost by giving up some “reps and warranties rights,” and for the loss in value of their retained portfolio.
• The refinance program would only benefit loans held by Fannie, Freddie, VA, and FHA. However, the report does say that non GSE loans that met GSE requirements at origination could be eligible.

Inherent problems with this plan

Numerous problems exist with this plan, if it is the one that the White House appears to be considering.

• The homeowners being considered for this program are NOT in default. They are paying their mortgages. They are being “rewarded” for meeting their financial obligations.
• If a homeowner is in trouble financially but not in default, a 1% reduction in the interest rate will result in a monthly payment reduction of $119.
• Income and debt ratios are being ignored for loan approval, though debt ratios and income are key elements for a borrower being able to repay a loan. If the housing payment is reduced by an insignificant amount, but the homeowner still has significant consumer debt, loan repayment is seriously jeopardized. Just lowering a monthly payment means little in and of itself.
• Loan to value is being ignored. The assumption is being made that by reducing the monthly payment, loan to value is a “side issue” of little importance. Yet, the higher the Loan to Value, the greater the likelihood of default, especially for 125% and above loan to values. (FHA loans from 95% to 97.5% loan to value have a 16% greater risk of default than those under 95%. Imagine the default risk percentage of 125% or greater.)
• Credit is not being considered. All a borrower needs to be is current on his home for three months. This allows any person with bad credit to refinance, no matter what their financial condition is. A borrower could have been in default four months previously, borrowed money from family to get caught up, made three months payments, refinance, and then start missing payments again.
• Mortgage Backed Security Investors will be having loans “retired” with greater rates of returns than the new securities. If they purchase these loans at 3.12 – 3.14 projected yields, the risk level will be greater than the expected returns. The only way that an Investor would buy these loans are because of the implied Federal Guarantee of Fannie and Freddie.
• 125% loans would be sold to TBA MBS whereby the exact conditions of the loans would be known. This may limit the pool of investors. An investor would not want to buy such loans with the elevated risk.
• If there is a second mortgage on the property, the holder of the second mortgage must agree to “subordinate” into second place again. The assumption is that by lowering the monthly payment on the first mortgage, the second mortgage would be in a more secure position, due to the lower payment. This program seeks to ensure their cooperation by force – “either subordinate or we will never do business with you again”. Since seconds are held by banks, etc., this would be a very powerful “incentive”.
• Homeowners delinquent on their mortgages would not be eligible. At this time, there are 6.8 million such homeowners. They are left with nothing but HAMP to turn to. We have seen how successful this is.

• Private Mortgage Insurers are being “asked” to reinsure these new mortgages, when such insurance existed previously. The loans were insured when the Loan to Value was from 80% to 95%. Now, the homes will be underwater. But according to the authors, since the monthly payment has been reduced, default risk has lessened, even taking into account the lack of equity in the loan.

  A Mortgage Insurer would have no incentive to insure a loan whereby there had been no credible underwriting, unless the government threatens to no longer do business with them.

• Fannie and Freddie will earn increased basis points from their current 12.5% – .25%. The new fee would be .40 basis points.
• If at some point in time, if the program was “opened up” to non GSE loans that met GSE guidelines at the time of origination, that would mean the GSE’s could refinance the loans and resultant government guarantees.

The Real Objectives and Outcomes

As with any new government program, we must look beyond the obvious to determine what the real objectives and outcomes of a program are. With this program, we don’t have to look far, because some objectives are readily admitted.

• The report estimates that mortgage payments will fall by about $70 – $80 billion.. What this really means is that it is being undertaken as a “new stimulus” for the economy, under the disguise of mortgage refinancing.
• Attempt to stabilize home values by refinancing to lower rates to keep people in homes. Finance underwater loans to avoid default. This will fail.
• Make the GSE’s more profitable through increased fees. GSE’s receive upfront cash flow from $54b – $72b. Allow the GSE’s to control more of the housing market.
• Bondholders to pay bulk of the costs of the program. Nearly all gains to homeowners come at the expense of the bondholders. (Total bondholder costs not given.)

In the end, this program will have little or no effect upon solving the housing crisis. It does not address the core issues of the crisis, which is a lack of real income growth in the US, excessively inflated home values, people who cannot afford the homes that they have now, those who cannot afford to buy a home at today’s prices, or the lack of private investors in the housing market.

Instead, the authors offer meaningless “solutions”. Homeowners who are not in financial trouble are offered the ability to refinance underwater loans at the expense of bondholders. The GSE’s, instead of being wound down, are allowed to further entrench themselves into the housing market. No attempt is made to entice private investors to return to home lending.

This is simply another “stimulus package” ready to fail.